Why Greece’s Rescue and Reform Policies Are Working

The European Stability Mechanism (ESM), which provides financial support within the European Union, was set up in 2012 to be a much-needed lender of last resort for sovereigns and to provide capital injections for banks in difficulty. Along with its predecessor, the European Financial Stability Facility (EFSF), the ESM has helped Greece, Cyprus, Ireland, Spain and Portugal when government – or bank — finances went awry. It not only provides loans to financially troubled nations, it also lays out game plans to help them pull through. But few understand how it works or just how much financial ammunition it can bring to bear in a crisis. In this Knowledge@Wharton interview, ESM secretary general Kalin Anev Janse discusses the organization’s capabilities, the European Banking Union, key risks for Europe’s economy and the situation in Greece.

An edited transcript of the conversation appears below.

Knowledge@Wharton: The ESM is only three years old and many people may not be familiar with it. Please tell us how it works.

Kalin Anev Janse: The European Financial Stability Facility (EFSF) was created in 2010 to safeguard the financial stability in the euro area in the wake of the most severe economic crisis in the last 80 years. It was the predecessor to the ESM. It started as a private company under Luxembourg’s law, but it was owned by the member states of the euro area.

Then the ESM was created in 2012. We provide loans to euro-area countries that experience or are threatened by financial difficulties. Over the last five years, the EFSF and the ESM have granted around €246 billion in loans. We have a combined balance sheet of around €970 billion, which is a bit more than $1 trillion U.S.

These loans are always granted alongside other institutions, including the European Commission, the European Central Bank (ECB), and the International Monetary Fund (IMF). And they’re only granted with strict conditions.

We work like this: We issue debt such as bonds and bills in the capital market. Our bills have maturities of three to six months and we offer long-term bonds up to 30-year maturities. It’s important to note that we do not use taxpayer money for our loans. The issuance is backed by over €80 billion in paid-in capital, which was contributed by our member states in the euro area.

“ … I think we did a good job helping these countries and now they are reform champions.”

This capital structure makes it easy for us to borrow money and issue debt in the capital markets at very low interest rates. In fact, we have negative interest rates at this stage on some of our shorter-term bonds.

The EFSF and ESM have supported Ireland, Portugal, and Spain with €85 billion. And all these countries successfully exited their financial assistance programs. They entered their program when they were in the midst of a crisis, we helped them restructure their economy and now they are very successful countries. For example, Ireland is boasting an impressive growth rate, one of the best in Europe.

Cyprus is still in the midst of a smaller program under the ESM worth around €9 billion. And Greece has recently begun a new program with us worth €86 billion over the next three years.

Since its inception, the ESM has been very important in managing the euro crisis. By the end of 2014, we disbursed €233 billion to these five countries. This is three times more than the IMF disbursed over the same period around the world. And we still have an uncommitted lending capacity of nearly €370 billion.

Knowledge@Wharton: Can you explain how the ESM connects with the European Banking Union?

Anev Janse: The ESM plays a very important role in the banking union. We were created as a backstop for euro-area countries. But in addition to providing loans to member states, we can also help and support financial sectors in these countries. We can lend money to ESM member states to recapitalize their banks.

For example, that’s what we have done in Spain, where we provided financing to recapitalize their banking system. At this stage we have disbursed €41.3 billion to Spain, €37.3 billion to Greece and €1.5 billion to Cyprus to recapitalize their banking sectors. We call this the “indirect bank recap,” which works as a backstop for sovereigns to help their banks.

We also have a new instrument we haven’t used yet, which is the direct recapitalization instrument. If a number of economic and political criteria are met in advance, this instrument could be used as a last resort tool when member states cannot solve their national banking problems. In this case, the ESM could buy the banks, manage the banks and appoint directors to the banks. We could take equity risks, invest in those banks and then reform them. For this instrument we allocated up to €60 billion.

A key condition before we could intervene directly in banks is to have a bail-in of some private creditors, who would have to write off their claims or convert them into equity. Costs of recovery of the bank would need to be shared — we must spare the use of taxpayers’ money.

Knowledge@Wharton High School

Additionally, the ESM can act as a financial backstop to other instruments that are created in the context of the banking union, if our shareholders agree.

Knowledge@Wharton: Does that mean that your organization is, in effect, the lender of last resort?

Anev Janse: For sovereigns, yes.

Knowledge@Wharton: Putting aside Greece for a moment, what are the major financial risks right now for Europe? What are you concerned about?

Anev Janse: The EFSF and the ESM played a key role for Europe to turn the page on the financial crisis. Thanks to our programs, certain troubled European countries remained in the euro. If we had not been there, that might not have been the case. They reformed and now they are growing again — some of them at an impressive pace.

“We also have a new instrument … the direct recapitalization instrument…. The ESM could buy the banks, own the banks, manage the banks and appoint directors to the banks … and then reform them.”

I believe the response to the crisis was, therefore, quite effective and it was managed successfully. There was criticism over how Europe responded to the crisis, but if you look at it retrospectively, I think we did a good job helping these countries and now they are reform champions.

Turning to the risks, I see two risks: political risk and complacency risk. Starting with political risks, for example, Greece was growing out of the crisis in 2014 but that upward trajectory was halted because of two national elections and one referendum, which is all part of a well-functioning democracy – we are not questioning that. However, financially and economically, this delayed necessary reforms and slowed down the recovery. It halted the increase in employment, for instance.

Political risks exist when you have 19 euro-area member states with different elections at different moments in time. It is part of the complexity in policy making that we have to manage in Europe.

Then there is complacency risk. Europe must continue to take actions to prepare for challenges such as the aging population and the preservation of our social model. And it’s also a short-term challenge to actually raise the GDP growth of the continent to a higher level.

From the perspective of the ESM’s mandate, you need to implement structural reforms in a fiscally responsible environment to put Europe on a path towards sustainable growth. All European countries should basically follow what we have done with the program in countries like Spain and Ireland. Those economies reformed. They are now the best growth performers.

At the European level, we also believe that there’s a need to deepen the monetary union and learn from past mistakes. The ESM is ready to play an important part in this debate.

Knowledge@Wharton: Let’s turn to Greece. Many analysts, including many at the IMF, say that it’s highly unlikely that Greece will ever be able to pay off all its debts – that the debt load is unsustainable. Then some within the EU say that Greek structural reforms must become effective before there can be debt relief or debt restructuring. The IMF seems to disagree and says their financial participation depends upon the provision of some debt restructuring for Greece. So in light of the latest agreement between Greece and its key creditors, what is your view about the timing of reforms and debt restructurings?

Anev Janse: Our latest debt agreement with Greece was a very important one, which allowed us to keep Greece in the euro area. And it actually empowered the government with a deal that is now accepted by an overwhelming majority in the Parliament. We believe that this ambitious reform program will stabilize the economy in Greece and restore its sustainable growth. And it will also honor the painful efforts that have already been made by the population.

Additionally, Greece does not need to start paying us back until 2023 under the previous program and 2034 under the new program. This form of debt relief can make a difference by creating fiscal space. But the key to the success of Greece is the consistent implementation of reforms in order to help it stabilize and grow its economy.

Greece has already had its maturities extended for up to 30 years, its interest rates lowered and it got a deferral on the payment of the interest as well. And we agreed that in the autumn we would look at a possible debt relief, if the program was being implemented. Again, there will be no nominal haircuts on the table. What we would look at is potentially extending maturities or further interest deferrals.

You also mentioned the creditors. We are by far the largest creditor to Greece with a total of €131 billion under the previous program and €86 billion under the new program. This means debt sustainability is a very important topic for us because, at the end of the day, we want to help them regain health and repay our loans.

There is a lot of talk about the correct level of debt-to-GDP. But that’s a negligible metric. Argentina went into default with a debt-to-GDP of 70% while Japan has a debt-to-GDP of more than 200% and does not have any debt issuance problems. Greece will have a debt-to-GDP of 150% around 2020. With such low interest rates and such long maturities I don’t think the debt/GDP ratio is the right metric to look at.

And finally, the IMF plays an important role here. They are a committed member of the team, they negotiate and then monitor Greece’s reform implementation. The IMF, the ECB, the European Commission and the ESM have joint missions together. We are confident that these measures we are putting in place will allow for strong implementation of reforms in Greece, and will convince the IMF to participate in this new program.

Knowledge@Wharton: Do you think that the austerity imposed on Greece has been the correct policy? Growth has been negative, or very slow, for years. Unemployment is still at depression levels. We all know youth unemployment has been holding above 50%. People are leaving the country. Businesses have been decimated. Any real recovery that would support a solid debt repayment schedule appears to be years away. Do you agree that these have been the right policies? Or could you suggest which policies may have worked better from the beginning?

“Europe must continue to take actions to prepare for challenges such as the aging population and the preservation of our social model.”

Anev Janse: We’ve faced this question several times during the crisis. There are no painless solutions when you are in a crisis. Imbalances are accumulated in the economy. Recession, unemployment and credit crunches become evident, and the country needs to adjust to the situation. It takes time for reforms and fiscal consolidation to have a positive effect on growth and employment.

In countries like Ireland, Spain and Portugal, unemployment is now clearly falling, export-based growth is picking up and the countries are emerging from their crises. Imbalances are being corrected, which encourages us to continue on the current track.

Greece was always the most difficult case with unparalleled structural imbalances. But the strategy had also been working in Greece, until recently. Greece was successfully growing out of the crisis in 2014. It topped the ECB ranking on structural reforms and was rising in the ranks on the World Bank’s Ease of Doing Business Index. It corrected several imbalances, such as the current account balance. Unit labor costs declined, making it cheaper for companies to produce and use labor in Greece, which helped boost competitiveness. And it achieved a primary surplus.

This was also reflected in the GDP: Greece achieved nearly 1% GDP growth in 2014. It had previously been projected to be 2% in 2015 and 3.5% in 2016. But these numbers were reduced over the last nine months. Hopefully, Greece will quickly be back on the same trajectory.

“The Bank Recovery and Resolution Directive (BRRD) was a landmark initiative to prevent the use of taxpayer money in bank bailouts in Europe.”

After several years of being out of the markets, Greece was able to also successfully issue five-year bonds in April 2013, three-year bonds in 2012. That’s why it was very difficult to see this whole progress stalling. In summer, with the additional measures taken as a condition for the new program and then the new set of reforms, which are part of the new program, the speed has picked up again.

Ultimately, some of the impact of the economic adjustments could have been avoided if Greece had taken more ownership of the program from the beginning. But overall, you asked whether this was the right strategy. If we look at the countries that we have supported, this clearly was the right strategy. These countries that have reformed have done much better than other euro area member states. They are now the reform champions.

Knowledge@Wharton: Spanish unemployment was sitting around 27% back in early 2013, and has since come down to about 22%. But this is years after the whole meltdown began. That’s where my question about Greece was coming from. But let me move on. Do you think it was the correct policy then for Spain and Ireland to assume so much of the private bank debt during the financial crisis? This was their policy decision to make, obviously, but it put the burden on taxpayers more than on the banks, which were responsible for the problem. So it’s true that private creditors took a small amount of the total losses. But in the future, should banks and bank shareholders and creditors be fully responsible for those losses?

Anev Janse: Let me first start with your comment on unemployment and economic progress. Unemployment is the last measurable metric to show whether a country is growing out of a crisis. Generally, you first see changing trends in advanced indicators and then returns independently to the bond market to issue long-term debt. Then, the real economy starts to show — namely GDP begins to grow. Unemployment always comes at the end of the chain. Companies need to have security that the economy is on the right track before they start recruiting new staff.

On your second question about the financial burden on taxpayers: A lot of the positions that were taken in Spain and Ireland were taken after the Lehman debacle. The key concern in Europe was to avoid similar crises where the impact on the economy could have been much worse. To some extent, this was avoided in Europe. But the strategy took a big toll on budgets and taxpayers. Ultimately, this is a lesson for Europeans and we wouldn’t want to repeat this scenario in the same way.

The Bank Recovery and Resolution Directive (BRRD) was a landmark initiative to prevent the use of taxpayer money in bank bailouts in Europe. It imposes a bail-in from the private sector. For example, depositors in Cypriot banks had to foot part of the bill of the bank recapitalization. This rule will be in place from 2016 onwards. But even now, no public money can be injected into banks without some bail-in from the private sector.

Join The Discussion

One Comment So Far

Edward Dodson

Protecting taxpayers from the imprudent lending practices of bankers is important, but this does not address the systemic problems in countries where the basic system of taxation favors rent-seeking over the production of goods and services. Belatedly, former World Bank economist Joseph Stiglitz has come to this conclusion, several years after he chaired the U.N. commission to examine the causes of the 2008 financial collapse and recommend measures to prevent a recurrencce.

Joseph Stitlitz has resurrected the analysis of the 19th century political economist Henry George, who recognized with remarkable clarity that the under-taxation of rents is the primary driver of boom-to-bust property market cycles. When credit is provided cheaply and with less than prudent underwriting standards employed, the result is hyper leveraged speculation. This drives up rents (capitalized into land prices) to levels that cannot be absorbed by businesses, consumers in need of rental housing, or most first-time homebuyers.

From what I have read, Greece is a society where rent-seeking dominates “economic” activity. The solution is comprehensive reform of the way the Greek government raises needed revenue. The Greeks would do well to take a page out of the writings of Henry George and begin to shift the burden of taxation of those who have long enjoyed rent-seeking privileges and off of earned income flows — off wages, off the value of actual capital goods and off commerce.